Risk and Return

Spring 2022

Chapter 10

Corporate Finance: The Core (4th Edition)

Berk/DeMarzo

§Risk and Return

§Common measures of risk and return – mean, variance,

standard deviation

§Measuring historical returns

§Historical trade-off between risk and return

§Common vs. Independent Risk

§Stock Portfolio Diversification

§Measuring Systematic Risk

§Beta – the sensitivity of a security’s return to the return of the

overall market

§Beta and the Cost of Capital – the Capital Asset Pricing Model

(CAPM)

§Historical returns on different investments

§In 2015, $100 invested at the end of 1925 (dividends and

interest reinvested) will have grown into

§S&P 500: $480,560

§Small Stocks: $4,637,913

§World Portfolio: $187,182

§Corporate Bonds: $23,147

§Treasury Bills: $2,043

Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global Financial Data.

§Why invest in anything else than small stocks?

§People hardly make 89-year investments

§Small stocks outperformed other assets on average – they

also experienced periods of large losses, most likely in

situations when people need money most (Great

Depression, Financial Crisis)

§On the other hand, Treasury bills enjoyed small but steady

gains each year

Source: Chicago Center for Research in Security Prices, Standard and Poor’s, MSCI, and Global Financial Data.

§Small Stocks had the highest performance, but also the

most variable returns

§Depending on the investment horizon, small stocks can do

worse than even Treasuries

§The goal in this chapter is to quantify the relationship

between risk and return

§Probability Distributions

§Summarizes information regarding risky investments –

assigns a probability PR to each possible return R

§Example: BFI stock currently trades for $100 per share.

You believe that in one year there is a 25% chance of the

share price being $140, 50% chance that it will be $110, and

25% chance that it will be $80. BFI pays no dividends